Abstract
The currency substitution and indexation infrastructure that has prevailed in Israel for over five decades had its inception before the onset of a major inflationary episode and included only minor and short-lived incidents of outright dollarisation. The present paper suggests that portfolio allocation models, based on the return-risk trade-off, provide a better understanding of these distinctive features of the Israeli financial scene than more conventional approaches to currency substitution based on money demand models. Some indicative results and policy implications from estimated equations based on the CAPM are presented.
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Notes
Brazil is another country where policy makers chose a financial system in which home-made forms of protection against possible future inflation, that is, various types of indexation, predominated but neighbouring Argentina went the dollarisation route. So Israel is not the only country that faced the choice.
The history of inflation and disinflation in Israel is well documented. The papers in Leiderman (1999) provide a recent survey. The authoritative reference on Israel's economic stabilisation is Bruno (1993).
It is still not possible to assess the full fiscal cost, even the financial part, since the government has not yet completed the privatisation of all the banks it acquired in the 1983 bailout.
This is one of the papers that described the Mundell-Tobin effect.
I cannot refrain from adding a personal note on this: I have served in a number of capacities as consultant in transition economies and I have no doubt that my experience, albeit limited, with financial repression in Israel stood me in very good stead as I attempted to understand the nature of transition problems.
For an informative and brief account of the early history of indexation following Israel's independence see Kleiman (1985).
The term is borrowed from Goodfriend (1993).
Shiffer (1999) provides a recent, comprehensive and insightful review of indexation in Israel over the years. Many of the institutional details in the present paper are taken from Shiffer's chronology of indexation and disindexation in Appendix 1 to that paper.
It is useful to relate this finding to the academic literature on the portfolio balance approach to money demand. The famous article by Tobin (1958) on Liquidity Preference as Behavior Towards Risk was written as a theoretical paper on money demand but it did not serve as the basis of much empirical work on money demand. As a store of value, narrow money is ‘dominated’, in the sense of finance, by interest-bearing time deposits. So are refrigerators, automobiles and any other durable goods that provide some service beyond being a store of value. Narrow money pays little or no interest so this aggregate is negatively related to the overall level of interest rates, a feature that is needed for the traditional monetary disequilibrium channel of monetary policy to work. Short-term, interest-bearing unindexed assets are generally found to be positively related to the overall level of interest rates and it is often difficult to find a relevant alternative asset that consistently has a higher yield in order to provide an estimate of the opportunity cost of these assets. Some large macro-models tried to incorporate extensive portfolio balance blocks of the type presented in a relatively well-known paper by Backus, et al. (1980), but this strand in the literature has not proven very successful. So it is not at all surprising that the seminal work by Tobin is remembered more for its contribution to the finance literature than for its contribution to the field of money demand. The portfolio balance approach to money demand is one of the favoured approaches used in the currency substitution literature. A good example of this work is Filosa (1995). While the estimated broad money demand functions in that paper have quite reasonable properties, we have serious reservations about whether this type of work could be a useful basis for conducting monetary policy. The principal components of these aggregates are likely to move unpredictably and in different directions in response to changes in expected interest rate and exchange rate movements. Therefore, even if the demand functions themselves remain stable when, say, inflation rises to moderate levels (a dubious assumption in my assessment), it is unlikely that there will be a stable relationship between such aggregates and policy instruments.
The key elements of financial reform that constituted the move from the regime of repressed financial markets to a relatively free, market-oriented one were implemented in the late 1980s and early 1990s. The choice of sample period and, hence to some extent, of specification, is influenced heavily by the importance of including only the period of relatively free markets. If this environment is maintained, there would be room to attempt to estimate richer models, including for example a time-varying risk-free rate, as the length of the sample and variation in the data permit.
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Acknowledgements
We gratefully acknowledge comments from Nissan Liviatan, Jeffrey Miller, Paul Wachtel and an anonymous referee and technical assistance from Yaffa Alon. Usual disclaimers apply.
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The authors are Director and Economist, respectively, Monetary Department, Bank of Israel.
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Offenbacher, A., Stein, R. Dollarisation and Indexation in Israel's Inflation and Disinflation: ‘There's more than one way to skin a cat’. Comp Econ Stud 45, 278–305 (2003). https://doi.org/10.1057/palgrave.ces.8100024
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DOI: https://doi.org/10.1057/palgrave.ces.8100024